Small Assets

Eric Silverman, managing director of Needham, Mass.-based Eastham Capital, is seeing a number of deals in the distressed sector. Between 2011 and 2012, his company fully invested its $34 million Fund II in about 17 properties and 4,500 multifamily units. Silverman has subsequently started Fund III, a $50 million fund that already has a number of properties in the pipeline. “There are a lot of opportunities, and distressed assets absolutely still exist,” says Silverman.Silverman’s experience may seem counter to the trend of disappointment among investors generally with the amount and quality of distressed multifamily opportunities in the past few years. “The expectation coming out of the down cycle is that it would be like the RTC days—a free-for-all. That didn’t happen,” observes Steven Jaffe, executive vice president and general counsel of Los Angeles-based BH Properties LLC. If anything, there may be even fewer distressed properties in the U.S. today. As real estate property performance and values improve, more capital becomes available to the sector, and interest rates drop ever lower.

Indeed, the inventory of distressed loans in the U.S. (held by CMBS servicers, banks, insurance companies, government agencies and others) has decreased by 15 percent to $30.6 billion in the fourth quarter 2012 compared to a year ago, according to Real Capital Analytics (RCA). And inflows of new distressed assets have fallen to $650 million in the fourth quarter—the lowest level since the cycle began, says RCA. RCA notes that increasingly more distressed properties are being resolved by refinancing/recapitalizations.

Nevertheless, Silverman and some other multifamily developers are able to keep their schedules full with upgrade projects. His secret to finding plentiful opportunities? Smaller properties, which are said to be more plentiful, less demanded by big money, and exhibit more favorable pricing. Indeed, in the universe of attached housing of two or more units, 19 percent of the properties are five- to 99 units, whereas only 2 percent are more than 100 units, according to National Multi Housing Council data. “Very, very large properties are few and far between, and if you are managing a $1 billion fund, it is very difficult to do deals investing in a few small projects at a time,” comments Silverman. “On the other hand, the U.S. is composed of a preponderance of small multifamily properties, and there is always distressed. It is a big market.” The returns on these distressed smaller properties, nevertheless, may no longer be at fire-sale prices and may be commensurate with today’s value-add or opportunistic returns.

Eastham Capital’s equity investments range from $500,000 to $5 million per project, although it has a preference for projects that are greater than 50 units. Value-add spending by Eastham Capital varies from $1,000 to more than $10,000 per unit. Investment time frame is about two to five years. Though Silverman agrees that purchase prices have increased, especially since multifamily has become the hottest sector, he says Eastham Capital is still able to aim for returns that would double the equity invested. The company looks for properties that would, post-upgrades, cash flow at least 10 percent per year of equity invested.

Silverman suggests, though, that investors need to search for properties outside of the primary markets. “If you focus on New York [and] San Francisco, you are not going to find great deals no matter the size of the property.” Eastham Capital seeks investments in A and B locations in the U.S. outside of the “sexy six” markets. The company’s transactions, typically suburban, have taken place in eight states, with the largest concentrations in Texas, Indiana, Mississippi and Ohio.

Eastham Capital recently sold two properties it purchased 18 months ago: one was a 300-unit foreclosed apartment community that it acquired from a special servicer, CW Capital. Eastham Capital invested about $8,000 per unit in the property, which is located in the Houston market. Another similar-sized property, located in Austin, was an undermanaged property that it purchased from a long-time partnership that had held the property for 20 years. Eastham Capital invested about $5,000 per unit into that project. Because of the short holds, the IRR achieved for both properties were in the high-teens, says Silverman.

Eastham Capital employs a strategy of finding distressed opportunities by partnering with seasoned local operators, whose principals are active in day-to-day operations. However, the company is extremely picky in selecting partners. “In six years, we have interviewed over 200 operators, and we invest with five,” says Silverman. These partners are the “eyes and ears” for Eastham Capital sourcing deals, whether through special servicers, banks, brokers or off-market opportunities. Eastham Capital is the limited partner but retains the majority of the equity, with major decision rights. “We believe all real estate is local. We partner with operators who are already in the market, who know the market and have skin in the game. They have to self-manage the property as opposed to using third-party managers.”

Madison Realty Capital, a vertically integrated financier-developer that both provides debt financing and purchases distressed loans and real estate assets, is another investor that specializes in smaller assets—in this case the sub-$50 million middle market. “Anyone who is complaining about the lack of product is not in the market. There are a lot of opportunities,” says Joshua Zegen, managing member and co-founder of Madison Realty Capital. In 2012, Madison Realty purchased approximately $100 million of debt and originated $50 million of loans, according to Zegen. The company concentrates on acquiring distressed notes. “We have found huge opportunities in the $1 million to $10 million loan size,” says Zegen.

Zegen says there is greater competition for larger transactions, which are chased by greater amounts of capital. “There are big opportunities in smaller properties, but there are very few businesses like ours that know how to scale to that size to best capitalize on those opportunities.” Michael Pestronk, CEO of Post Brothers Apartments, adds that smaller distressed assets are also “generally easier to acquire because they are less sophisticated entities involved than with larger assets whose owners [or] lenders are generally much more well capitalized.” Larger distressed assets’ more sophisticated owners “may be able to defend distressed assets, pay for the best legal counsel and otherwise not capitulate to predators of troubled assets at a fire sale price,” observes Pestronk. Post Brothers Apartments is active in the Philadelphia area, though it does not focus on investing in smaller distressed properties.

The firm may also present an opposing argument to the one that it is difficult to land assets in the coastal markets. Madison Realty Capital focuses its distressed debt purchasing business primarily in the Northeast and is particularly active in the five boroughs of New York City. Since 2010, the company has purchased about $400 million of distressed commercial real estate assets, mostly in the form of distressed debt. The loans may be subsequently resolved through, for example, discounted payoffs by the borrower, acquisition of the deed by Madison Realty or loan restructurings, says Zegen.

Distressed transactions in New York City that Madison Realty announced in 2012 include the purchase of three non-performing senior notes secured by multifamily and industrial properties in Park Slope, Brooklyn; Woodside, Queens; and West Harlem in Manhattan. The note seller was a community savings bank. Another transaction in 2012 was the purchase of a note and deed for 385 Union Avenue, a six-story, 53,000-square-feet residential rental property in Williamsburg, Brooklyn. The original owner had defaulted on the construction financing in 2009. The seller of the loan was a bank that had taken over the original failed lender on the project through an FDIC loss share deal. The 47-unit property features 24 parking spaces and is substantially complete and approaching full occupancy.

The company seeks to purchase distressed debt at a discount of about 65 to 80 percent of the underlying real estate value, says Zegen. That means it will purchase debt even at full note value if the price is 65 to 80 percent of the property value. For example, if the balance on the loan is $6.5 million, Madison Realty may be willing to pay full price if the property is worth $10 million. It looks for IRR in the high teens in line with average returns for value add investments today.

Madison Realty Capital sources most of its distressed asset opportunities directly from lending institutions. It has acquired debt from more than 30 banks since 2010, including Sovereign Bank, TD Bank and New York Community Bank, says Zegen. Earlier in the cycle, the national “big banks,” such as Capital One and J.P. Morgan, were the most active bank sellers of distressed debt, observes Zegen. Although Madison Realty is still purchasing from these banks, lately the smaller regional, savings or community banks have become more active.

On the surface, distressed property opportunities may appear to be winding down as the economy improves, but Zegen believes that the distressed market still has at least two to three years to run its course. While there seems to be a drop off in problem loans of late as indicated by RCA, and even if more maturing loans may be able to survive now, the wave of expiring loans underwritten at the peak of the market is set to increase in the next few years. Data from MBA show that non-bank mortgage maturities will drop from $151 billion in 2012 to $108 billion and $109 billion in 2013 and 2014. However, the volume will begin spiking again, to $163 billion in 2015, $215 billion in 2016 and $199 billion in 2017.

Banks may be encouraged to sell more properties as Basel III regulations force them to post more money for non-performing loans in the next few years, says Zegen. And as property values increase, banks have greater flexibility to sell their loans compared to 2010. Also, smaller banks, with their improving balance sheets, are selling more now, as they are in a better position to write down the losses, he adds.

Says Pestronk: “There are lots of dilapidated buildings out there. If it looks dilapidated, there is an endless supply of that. Think of Sixth Avenue in the ‘30s [in Manhattan]. The buildings that are run-down there, they are all for sale.”

Distressed Property Types

Financial / Economic Distress

■ The current owner overpaid for
the property, making it difficult or nearly impossible to cover the
property’s expenses.

■ The financing on the property is
too onerous for the property’s
rent roll to support the monthly debt payments.

■ An unexpected change in the local economy can have a significant impact on a multifamily community.

Physical Distress

■ Physical distress is usually found in properties that have been neglected by their current owners.

■ This occurs when those owners do not make the reinvestments necessary to maintain their properties and maintenance is deferred.

Ownership Distress

■ Many properties are owned in long-term, closely held private partnerships. After a number of years, some partners may die, divorce or have other life changes.

■ Due to the economic turbulence of 2008, many institutional property owners need to dispose of some of their assets to deleverage their balance sheets and raise cash.

■ Some properties are already in receivership and owned by banks or special servicers.